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EKO2111: Macroeconomics II Problem Set 5 Suggested Solutions

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The document discusses macroeconomic concepts like the New Keynesian model, monetary and fiscal policy, and how the central bank should respond to different economic shocks.

Keynesians argue that prices are sticky in the short run due to menu costs, which prevents them from adjusting immediately to changes in supply and demand. This leads to involuntary unemployment.

In the New Keynesian model, monetary policy is determined by the central bank's target interest rate. The central bank directly controls the nominal interest rate and aims to keep inflation at a target level while minimizing deviations of output from potential.

EKO2111: Macroeconomics II

Problem Set 5
Suggested Solutions

1 Questions for Review (FYI. Not Graded)


1. What is the main argument of Keynesians in favor of sticky prices?

2. How is monetary policy determined in the New Keynesian model? What is the central bank’s target, and
what does the central bank control directly?
3. Why is monetary policy not neutral in the New Keynesian model? What are the effects of a change in
the central bank’s target interest rate?

4. How do Keynesians justify intervention in the economy through monetary and fiscal policy?
5. Explain why the Phillips curve relationship in the basic New Keynesian model takes the form it does.
6. Explain the concept of rational expectations. If the nominal interest rate increases permanently, what
effect does this have in the NKRE model in the long run?

7. What is the Taylor principle, and how does the Taylor principle go awry?
8. What is the basic neo-Fisherian idea? Explain how the neo-Fisherian monetary policy rule acts to achieve
good economic results.

2 Problems (100 points)


1. (10 points) Suppose that real output decreases temporarily in the New Keynesian model.
a. What are the effects on government spending, consumption, investment, price level, employment, and
real wage?

Solution: If real output decreases, then the output demand curve shifts to the left. With a fixed
interest rate target, government spending decreases, investment stays constant, consumption decreases,
employment decreases, and the real wage decreases.
b. Are these effects consistent with the key business cycle facts from Chapter 11? What does this say
about the ability of firms to deal with this temporary shock?

Solution: Everything fits the data, except that the price level and investments are acyclical and
average labor productivity is countercyclical. A firm must foresee these shocks that are likely to affect
future market conditions and its future profitability.

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2. (20 points) Some macroeconomists have argued that it would be beneficial for the government to run a
deficit when the economy is in a recession, and a surplus during a boom. Does this make sense? Carefully
explain why or why not, using the New Keynesian model.

Solution: Under the assumption that Ricardian equivalence holds, so that the timing of taxes is irrelevant,
the deficit does not matter. What matters in the basic New Keynesian model is the level of government
spending. If fiscal policy is the only stabilization tool, then government spending should increase when the
output gap is large and decrease when it is small, so government spending should be countercyclical, not
the deficit. However, some Keynesians argue that credit market imperfections matter, and this implies that
changes in the timing of taxes can affect consumer spending. This would add another stabilization tool, and
would tend to imply that the deficit would be countercyclical.
3. (30 points) In the New Keynesian model, how should the central bank change its target interest rate in
response to each of the following shocks? Use diagrams and explain your results.
a. There is a shift in money demand.

Solution: There should be no change in the target rate. The money supply changes with the shift in
money demand, with the target rate unchanged. The output gap therefore is unaffected by the money
demand shift.
b. Total factor productivity is expected to decrease in the future.
Solution: This shifts the demand for investment goods, and shifts the output demand curve to the
left. The central bank should reduce its target rate to keep the output gap at zero.
c. Total factor productivity decreases in the present.
Solution: This shifts the output supply curve to the right. The central bank should increase its target
interest rate, leaving the output gap at zero.

4. (20 points) In the basic New Keynesian model, suppose that there is an increase in the future marginal
product of capital. Explain your results with the aid of diagrams.

a. Suppose that the central bank keeps the nominal interest rate at its initial value. What will be the
effect on current inflation and on output?
Solution: If the central bank keeps the nominal interest rate at its initial value, then the central bank
achieves its inflation target but not its output target, and there is a positive output gap.

b. Suppose that the economy initially faces an increase in anticipated future inlation and a zero output
gap. When the shock occurs, what should the central bank do?
Solution: When there is an anticipated future inflation, the best response of the central bank for an
output gap of zero is to increase the nominal interest rate one-for-one with the increase in anticipated
inflation. The central bank then hits its output target, even if inflation is greater than the inflation
target.

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5. (20 points) Suppose initially that inflation is at the central bank’s target and the output gap is zero. Then,
government spending goes down. Determine, with the aid of diagrams, how the degree of price stickiness
affects the central bank’s optimal response, and explain your results.

Solution: 2. Initially, equilibrium is at point A, with output at its efficient level Y1 , and inflation at the
inflation target i∗ . Suppose two cases, a Phillips curve with more sticky prices, P C1 , and a Phillips curve
with less sticky prices, P C2 . Note that the Phillips curve with more sticky prices is not as steep–for a given
change in output there is a small change in the inflation rate. When government spending goes down the
output demand curve shifts to the left, which causes a decrease in the efficient level of output. Suppose the
new efficient level of output is Y2 . Then, the central bank could decrease the nominal interest rate from R1
to R2 , which would keep the inflation rate at the target, no matter what the slope of the Phillips curve is.
But there would be a negative output gap, as output would be above the efficient level. Alternatively, the
central bank could reduce its nominal interest rate target to R3 , so that output would be at its efficient level.
However, in this case inflation would be below target–by a larger amount in the case in which prices are
less sticky. The optimal choice of a nominal interest rate target for the central bank is something between
R2 and R3 , and the choice will depend on the slope of the Phillips curve. For example, if the central bank
chose R = R3 , then the marginal gain from reducing the nominal interest rate would be larger with a steeper
Phillips curve (because the inflation rate is further from the target). Thus, with Phillips curve P C2 , the
optimal point chosen on the Phillips curve would be a point such as F , as opposed to a point such as E
with Phillips curve P C1 . That is, with more price flexibility, the central bank would choose a lower nominal
interest rate target, implying higher output and lower inflation than with less price flexibility.

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